If you’re a coffee drinker you might enjoy a cappuccino from time to time. A great one has some froth on top and makes for an enjoyable experience – provided you don’t drink too much or too quickly. One way to describe markets in 2020 is “frothy.” Frothy markets are those in which prices begin to detach from fundamentals. I saw a list of the ten best-performing stocks of 2020 recently and the numbers are truly eye-popping. The leader is a small pharmaceutical company with a COVID-19 vaccine candidate. It has returned 3,030% this year. The average return of the 10 top-performing stocks is just over 1,000%. Some of these returns will prove to be durable. Some may reverse and could do so quickly. Many investors bear the scars of chasing yesterday’s winners. Investments in some of the high-flyers of the tech bubble took years to break even, and in some cases never did.
Now, before you think I’m throwing a wet blanket on the idea of investing in some of the world’s most innovative companies I can assure you that the managers we use in our clients’ investment portfolios are looking at, and in some cases buying and holding, the kinds of stocks you’re seeing in the headlines. While they may be doing this, they are doing it in a measured way, understanding the risks associated with these companies and balancing those risks by diversifying portfolios into a range of companies.
We’ve been pleased to be beneficiaries of some of this “froth” but are also thinking ahead to what we think looks attractive for 2021. This gets back to a simple mantra we’ve repeated many times this year – “innovation and cash flow.” We’ve owned some of the “innovators” and will continue to own them. That said, we’re interested in opportunities in quality, cash-flowing businesses that have been overlooked by the investment community and are trading at reasonable valuations. There are wide swathes of the stock universe that are trading at a fraction of the prices of some of this year’s top-performing companies (while at the same time generating a lot more cash).
It is our belief that ultimately stock prices gravitate toward cash flows. There are a number of companies on this year’s leaderboard that don’t generate a lot of cash, and it’s a bit of a head-scratcher to figure out if they will ever generate enough cash to justify their valuations. Keeping that in mind, we’re being careful not to get burned from the froth in this year’s market. There are good values in segments of the market that have the potential to recover in 2021 as we begin to put COVID-19 in the rearview mirror. Tiptoeing the line between innovative, expensive companies and cash-flowing, cheap companies requires caution. Our approach is to not lean too far in either direction. Fail to own the innovators and you might miss the next Amazon. Fail to own reasonably valued businesses and you can end up taking years to make back your investment. One way we’re seeking to avoid some of the froth is in owning foreign stocks and small cap stocks, neither of which have been leaders in 2020.
If this coming year looks different than 2020 (and we all hope it does) it’s very possible the frothiest names of 2020 aren’t at the top of the leaderboard this time next year.
This WealthNotes article was written by Alex Durbin, Portfolio Manager